To the annoyance of some shareholders, Snap-on (NYSE:SNA) shares are down a considerable 34% in the last month. That drop has capped off a tough year for shareholders, with the share price down 33% in that time.
All else being equal, a share price drop should make a stock more attractive to potential investors. In the long term, share prices tend to follow earnings per share, but in the short term prices bounce around in response to short term factors (which are not always obvious). The implication here is that long term investors have an opportunity when expectations of a company are too low. One way to gauge market expectations of a stock is to look at its Price to Earnings Ratio (PE Ratio). Investors have optimistic expectations of companies with higher P/E ratios, compared to companies with lower P/E ratios.
Does Snap-on Have A Relatively High Or Low P/E For Its Industry?
Snap-on’s P/E of 8.30 indicates relatively low sentiment towards the stock. If you look at the image below, you can see Snap-on has a lower P/E than the average (13.7) in the machinery industry classification.
This suggests that market participants think Snap-on will underperform other companies in its industry. Since the market seems unimpressed with Snap-on, it’s quite possible it could surprise on the upside. You should delve deeper. I like to check if company insiders have been buying or selling.
How Growth Rates Impact P/E Ratios
Earnings growth rates have a big influence on P/E ratios. When earnings grow, the ‘E’ increases, over time. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. And as that P/E ratio drops, the company will look cheap, unless its share price increases.
Snap-on’s earnings per share grew by 4.3% in the last twelve months. And earnings per share have improved by 12% annually, over the last five years.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. So it won’t reflect the advantage of cash, or disadvantage of debt. Theoretically, a business can improve its earnings (and produce a lower P/E in the future) by investing in growth. That means taking on debt (or spending its cash).
While growth expenditure doesn’t always pay off, the point is that it is a good option to have; but one that the P/E ratio ignores.
How Does Snap-on’s Debt Impact Its P/E Ratio?
Net debt totals 17% of Snap-on’s market cap. That’s enough debt to impact the P/E ratio a little; so keep it in mind if you’re comparing it to companies without debt.
The Verdict On Snap-on’s P/E Ratio
Snap-on trades on a P/E ratio of 8.3, which is below the US market average of 11.8. The company hasn’t stretched its balance sheet, and earnings are improving. The P/E ratio implies the market is cautious about longer term prospects. What can be absolutely certain is that the market has become more pessimistic about Snap-on over the last month, with the P/E ratio falling from 12.5 back then to 8.3 today. For those who prefer to invest with the flow of momentum, that might be a bad sign, but for deep value investors this stock might justify some research.
Investors should be looking to buy stocks that the market is wrong about. As value investor Benjamin Graham famously said, ‘In the short run, the market is a voting machine but in the long run, it is a weighing machine. So this free visual report on analyst forecasts could hold the key to an excellent investment decision.
But note: Snap-on may not be the best stock to buy. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio below 20).
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.
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